With all the business valuation methods available, you may wonder which ones work best for valuing a start-up business.
First, let’s consider the special challenges faced by a young business that affect what it is worth.
Conflicting requirements for start-up valuation
Unlike an established business, startup companies have little history of financial performance. Frequently a young company is just beginning to implement its business plan and needs critical resources to reach its objectives. The two key requirements any start-up has is access to funding and talented employees. These two requirements often create conflicting views of what the start-up business is worth.
Reasons for showing a high business value
Many start-up business owners look for outside equity or debt financing to meet the business financial needs beyond the prototype stage. When owners look for funding from early stage investors, such as angels and venture capitalists, their goal is to raise as much capital as possible without giving up a large portion of their business ownership. This strategy tends to favor high business values – the higher your pre-money valuation, the less business ownership you give up to raise the amount of capital required.
Key employee stock options call for low business value
On the other hand, you would like to attract and retain key employees with cheap stock options. Bear in mind that tax and securities authorities require that the stock option strike price be at the current fair market value. This means that you need a low start-up business value for realistic and defensible stock valuation!
Disguised compensation pitfall
As your young company prepares for an IPO, you may be tempted to issue cheap stock options to founders and key employees. However, government securities agencies such as the US Securities and Exchange Commission (SEC) keep a watchful eye on such late stage option grants and IPO stock prices.
If they believe that the IPO price is too high compared to the option strike price, they may assume that you underpriced the pre-IPO shares below their fair market value. In the interest of protecting all company shareholders, the SEC may take these option grants as a disguised form of compensation. Needless to say, this may have significant tax and legal consequences for the business and its founders.
Approaches to valuing a start-up business
As with an established business, you have three key approaches to measuring the value of startups:
- Asset approach.
- Market approach.
- Income approach.
We discuss the fundamental economic principles behind each of these approaches in ValuAdder Business Valuation Guide. The question you may have: what is the best choice of approaches and valuation methods to determine the value of a young company? Let’s consider how each valuation approach fits this situation.
The asset approach and its valuation methods generally work well for asset-rich businesses. A typical technology-based start-up has most of its value in a set of intangible assets known as Intellectual Property. Generally, it is quite hard to assign a value to such assets within a start-up. Their cost may vary considerably and there is no reliable history of income such assets can produce. As a result, the methods under the asset approach are rarely used to value a young start-up.
The market approach to valuing a business relies upon relevant comparisons to similar businesses that have actually sold. Since few young start-ups sell, there is little evidence of selling prices that offer a good comparison. This makes estimation of the start-up value difficult under the market approach.
This leaves us with the income approach and its valuation methods. These methods require income projections and assessment of the risk associated with receiving the income. Owners of a start-up need to prepare detailed business plans which include financial performance forecasts. In the absence of actual financial performance history, these forecasts can be used as inputs into the income-based business valuation methods.
Valuing a start-up: discount and hurdle rates
For a young company, it takes a leap of faith to assess how realistic its forecast is. Are the projected sales levels achievable? What will the competitors do in response and how will it affect the product or service prices? How well is the key intellectual property protected against cheap substitutions? These and many other questions need to be addressed when assessing the risk.
This risk is translated into the appropriate discount rate, another key input into the income-based valuation, such as the Discounted Cash Flow. It is not unusual to see discount rates in the 30 – 50 % range when valuing a start-up. A 50% annual return means that your original investment grows to over 11 times its initial value within 6 years.
Bear in mind that a venture capital firm may have a “numbers” strategy in its investment portfolio. For example, the VC can expect that only one out of every ten portfolio companies succeeds. If the remaining nine investments don’t do well, the returns realized from the successful company must compensate for the loss. This return may be built into the VC‘s hurdle rate – the required rate of return used to screen proposed investments.
If you know what the investor’s hurdle rate is, then you can check your financial projections to ensure that your business growth matches the VC’s investment profile. For example, if the VC expects 50% annual return and is prepared to wait for 6 years for a liquidity event (IPO or business sale), then your business plan must support an 11-fold increase in business value.